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The volatile start to the new year has all eyes on the Federal Reserve and its increasing hawkishness. As the Fed prepares to raise interest rates later this year, we look at reverse repurchase agreements and what they mean for the markets.
As part of the Federal Reserve’s efforts to maintain monetary policy and manage liquidity, the New York Fed engages in temporary transactions where reserve balances of excess liquidity are added to or reduced through repurchase (repo) and reverse repurchase (reverse repo) agreements. These operations have a short-term, self-reversing effect on bank reserves. Repurchase agreements involve the Fed purchasing Treasury securities from a counterparty (typically a large institution with excess reserves), with an agreement to resell the securities back at a slightly higher price, representing a small rate of interest. The repo transaction temporarily increases the supply of reserve balances in the banking system and provides liquidity. Reverse repurchase agreements involve the opposite, where counterparties temporarily purchase Treasury securities to be sold back at a later date. Reverse repo transactions help alleviate any undue downward pressure on the effective federal funds rate and set a floor under overnight interest rates by providing a short-term alternative investment for large institutions with excess liquidity reserves.
After a period of dormancy in the beginning of 2021, the Federal Reserve’s overnight window for reverse repurchase agreements saw a rapid rise in demand when the counterparty limit for reverse repos was raised from $30B to $80B in March. This trend continued to accelerate when the limit was again raised to $160B in September, closing out the year at a record level of $1.91T in volume. Low interest rates and the Fed’s quantitative easing efforts presented large institutions with a challenge as to where to invest record levels of excess liquidity reserves. The solution has so far been to make use of the overnight window and earn minimal interest via a risk-free investment in Treasuries.
Time will tell how the Fed will execute its monetary policy changes this year and how markets will respond to that shift. Institutions currently utilizing reverse repurchase agreements may change course once they have higher yielding alternatives, with the impact to the economy and market dependent on where those reserves go. Marquette will continue to carefully follow policy decisions from the Federal Reserve and monitor other indicators, like the demand for overnight repurchase agreements, to help provide clarity during this period of heightened market volatility.
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